How not to rescue home loans

February 26, 2008

New fire engines are being built by Congress to douse infernos in the housing markets. These rescue vehicles, coming eight months before an election, are likely to be popular. In effect, though, they may hurt more than they help.

The various proposals could end up rewarding unwise buyers and investors, tap taxpayers' money, and harm growth in home ownership.

One proposal would ease US bankruptcy rules to allow judges to reduce interest rates and lower mortgage payments for those in financial ruin and facing foreclosure. The concept seems humane for the estimated 1.8 million borrowers who may not be able to cope with adjustable-rate mortgages soon to be reset to higher rates. But it will hurt millions more applying for home loans.

Here's why: Judges would be expected to guess a home's current value and "cram down" the mortgage to that level. To cover the risk of that uncertain intervention by courts on old mortgages, banks would need to raise interest rates on new ones. And such risk would slow the pooling of home loans for resale into securities – a practice that still helps to lower interest rates.

A better route is the Treasury Department's new Project Lifeline. This voluntary plan, agreed to by six major lenders, would grant an added 30-day grace period for homeowners in foreclosure proceedings, allowing more time to work out refinancing. The plan comes after an earlier volunteer one negotiated by Treasury in which major lenders agreed to freeze interest rates on troubled subprime loans for five years. Such collective and private responses help build on a mortgage lender's interest in avoiding costly foreclosures.

Another proposal in Congress would set up a new federal agency to buy distressed mortgages from lenders, and then supposedly resell them later on the presumption that the housing market will revive.

But can federal workers really know the price to pay for today's complex and wobbly subprime mortgages?

The concept of federal buyouts of bad mortgages was tried during the Great Depression to help those without jobs. But it only succeeded when the economy revived during World War II.

Peter Orszag, director of the Congressional Budget Office, warns that today's taxpayers could pay a high price if government misjudges market prices and ends up paying for bad loans. Modern financial markets are too complex for quick federal fixes.

A possible better idea is one proposed by the agency that oversees federal savings and loans. Owners whose house values are now less than their mortgages could refinance such loans if the lender saw a risk of the owner simply walking away from the property. The difference between the old and new loan could be sold as a warrant, or "negative amortization certificate," with investors buying such financial paper on the assumption of a growing housing market.

Congress needs to be patient while financial markets sort out the credit mess left by a burst housing bubble built in part on dubious mortgage-selling practices. Rushing to the rescue with the heavy hand of government can have unintended consequences, such as taxpayer bailouts for those who took on too much risk with financial illiteracy. Sometimes the impulse to help can backfire.